Don’t Follow The Crowd

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Editor’s note:Jules Maltz is a General Partner at Institutional Venture Partners (IVP), a late-stage venture capital firm based in Menlo Park. You can follow him on Twitter @julesmaltz.

Whenever I’m about to make a new investment, I always think about the 2×2 matrix I learned from Andy Rachleff, a former partner at Benchmark Capital.

The idea is that if you make a new venture investment (or start a company), you can either be “right” or “wrong” and you can either be “consensus” (following the crowd) or “non-consensus.” Everyone knows that if you’re wrong, you’re not making any money. But the interesting part of the chart above is that being right and consensus isn’t great for your returns either. The big money, as any horse racing handicapper can tell you, comes when you’re right and you don’t follow the crowd.

Fortunately (for the premier handicappers and savvy venture capitalists), the crowd’s opinion is often based on “hype” rather than reality. In an efficient market, every company would fall somewhere along the dashed black line in the chart below (with hype equal to fundamentals).

In reality, however, the venture market is inefficient. There are many companies (which I’ll decline to name) whose hype dramatically exceeds fundamentals and there’s a whole set of companies (which many of us don’t know) who are the opposite. I’m probably wrong as much as I’m right in investment decisions, but my two favorite types of companies exhibit the characteristics of either oval A or B:

Hidden Gems (oval A): These are the companies who have strong fundamentals that exceed their hype. They are often in a market, or geographic location, not widely followed by the venture industry and/or have transitioned their business in a way that the market doesn’t quite yet understand. Examples of these types of investments in our portfolio include Buddy Media (2010) and Fleetmatics (2010), and outside our portfolio include RPX (2009), Palantir (2008), and Service-now (2006) If you’re right, the company will grow in both hype and fundamentals. If you’re wrong, the company will fade quietly away without anyone noticing. You know you’ve done a Hidden Gem investment if people tell you:

What do they do again?

Seems like a niche play

That’s an “interesting” investment

Have fun flying to X for Board meetings! (sarcastically)

While Hidden Gems are clearly non-consensus because their fundamentals exceed their hype, you can make a non-consensus investment in a “hyped” company if you believe it will outperform the crowd’s expectations. These rare (and expensive) companies are called:

Breakouts (oval B): These have early hype, but haven’t entered the mainstream. The consensus view is that they could be “roman candles,” which will soon come crashing down to reality (the blue dotted line). You can be non-consensus if you think the opportunity is much larger than even the early hype suggests. While Hidden Gem investing employs the buy low, sell high strategy, Breakout investing is buy high, sell higher. Examples of these types of investments in our portfolio include Twitter (2009) and Zynga (2008), and outside our portfolio include Square (2011), Foursquare (2010), and , most famously, Facebook (2006). If you get these investments right, fundamentals do grow faster than anyone imagined and you have an incredibly valuable business. If you get these wrong, the consensus view was correct and you massively overpaid. You know you’ve invested in a Breakout company if people say the following:

Wow. I can’t believe you paid that valuation

It just seems like a fad

Won’t XYZ crush them?

Remember what happened to Friendster

Ultimately, regardless of where your company is on the chart, you always want to be moving to the right as quickly as possible. So, if you’re a Breakout company, feel lucky to get some hype and take advantage of it by raising money, hiring great people, and focusing on fundamentals. And, if you’re a Hidden Gem, don’t feel bad that nobody knows you – just remind them that you’re non-consensus!